History provides lessons as austerians battle fiscal crises
Part II of five-part series "Austerity on the Island"
At the first Puerto Rico Oversight Board public meeting, Board Member Andrew Biggs said he had done research showing that the best policy practices for countries struggling with debt are ones that place much more weight on spending cuts than on tax increases.
In the paper, “A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked,” which Biggs authored with Kevin Hassett and Matthew Jensen, they said that: “The average expenditure share for successful consolidations is 80 percent if inclusive of our calculations and those from [others].” They argued that cuts should be focused on government wages and the provision of social transfers.
Biggs’ preference is in line with that of Alberto Alesina, an exponent of austerity for countries with large debts. The Harvard University professor has been writing about government fiscal policy for much of his 33-year career. He authored a book with Carlo Favero and Francesco Giavazzi, “Austerity: When it Works and When it Doesn’t,” published earlier this year.
The authors argue that government debt in major industrialized countries should be reduced. First, large public debts and unfunded pensions “imply a redistribution between current generations and future ones who cannot vote.” This is unfair, they say.
Second, when interest rates go higher, as they will do sooner or later, it will become much more painful to finance annual deficits.
“Third, in some countries high debt levels may generate default risk, high interest rates, capital outflows (as in Greece), and a debt crisis that may impose austerity when it is particularly costly,” they wrote.
Their book is a study of 200 multi-year austerity plans from 1981 to 2014 in 16 major industrialized free-market economies.
They acknowledge that austerity causes short-term economic contractions. However, they say that austerity is sometimes necessary and desirable, and that it can promote long-term economic growth.
Through a mathematical analysis of the 200 cases, the authors claim to show that plans that try to reduce government deficits through spending cuts have better outcomes than those that focus on tax-increases. Spending cuts-based plans have led to reduced government debt-to-gross domestic product ratios, while tax increase-based plans have had the opposite effect. Spending cuts-based plans have also harmed the economy less.
Alesina and his co-authors say that governments that cut spending give society’s participants confidence that the deficit problem will be permanently addressed. And this confidence helps promote economic growth.
For contrast, perhaps the best-known contemporary economist arguing against austerity policies is Paul Krugman, a City University of New York professor and New York Times columnist.
He made a case against austerity in a 2015 essay in The Guardian newspaper, “The Case for Cuts was a Lie. Why Does Britain Still Believe It? The Austerity Delusion.”
In 2010 British Prime Minister David Cameron warned that Britain’s growing government debt could trigger a crisis and argued for austerity policies to cut the annual deficit. Krugman was writing in response to the policies of Cameron and his successors in Britain. Krugman wrote primarily about the experience of European countries in the preceding eight years.
Not all of Krugman’s arguments are completely relevant to Puerto Rico and some of them concern countries in different circumstances than Puerto Rico.
Krugman presented a scatterplot of countries on a graph with the rate of gross domestic product growth on a y-axis and the harshness of austerity on an x-axis, both measured 2009 to 2013. The International Monetary Fund is the source of his data. Generally, those countries with the least austerity had the best economic growth and those with the most had the greatest contraction. Greece had the most austerity and the greatest contraction.
Krugman says this shows that some pro-austerity economists’ talk of the expansionary impact of austerity back in 2010 was “foolish.” He said that Alesina and others have looked at cases that are quite different from those in Europe since 2010 to argue for the value of austerity there.
Alesina and many other pro-austerians have acknowledged austerity’s short-term negative economic impacts. After the period depicted by Krugman’s scatterplot, most of the countries that had experienced austerity achieved economic growth. Britain, Portugal, and Spain’s economies have been growing since 2014. Indeed, Britain, which was going through austerity at the time, in general had gross domestic product growth from 2009 to 2014, albeit at a low level.
Among other critics of austerity is Brown University Professor Mark Blyth, who said in his book “Austerity: The History of a Dangerous Idea,” that excessive government spending wasn’t the primary factor in Europe’s sovereign debt crisis of the past decade, except in Greece. “For everyone else, the problem is the banks that sovereign [governments] have to take responsibility for, especially in the Eurozone.” The “Eurozone” refers to the 19 European countries that use the euro as their currency.
The European banks’ assets were a far larger portion of gross domestic product in the Eurozone nations than the U.S. banks’ assets were in the U.S. GDP. Prior to the Great Recession many of the European banks were over-leveraged and had lent to many questionable borrowers, Blyth said. Europe’s leaders were worried about the effects of deep or widespread debt markdowns on the banking system and how this would affect their economies, Blyth added.
According to Blyth, in the context of their inability to expand their own money supply or devalue individual countries’ currencies (because they were all linked in the euro), European countries in the midst of a downturn might normally have considered defaulting on debt, Blyth said. But since this would have blown up the banking system at the heart of the economy, Europe’s leaders turned to austerity.
In this way Blyth explains the prevalence of austerity policies in some European nations this past decade. While some economists have argued that with austerity some European countries returned to a long overdue responsibility, Blyth said the policies were just the result of peculiarities of Europe’s economy and the use of a single currency by many countries.
Blyth criticized an essay by Alesina and other pro-austerity economists that aimed to show that in an economic downturn government spending should be cut decisively. He said that the economists used poor examples to support their thesis: Denmark in the 1980s and Ireland in the late 1980s.
Blyth cited a Congressional Research Service report that found: “Withdrawing fiscal stimuli too quickly in economies where output is already contracting can prolong their recessions without generating the expected fiscal saving. This is particularly true if the consolidation is centered around cuts to public expenditures … and if the size of the consolidation is large.”
Blyth said that pro-austerity economists frequently cite the experience of Estonia, Latvia, Lithuania, Romania, and Bulgaria in the Great Recession to support their conclusions. During this period their economies underwent great stress but, according to the austerians, austerity helped them return to economic growth in this decade’s early years.
Blyth said that Latvia was a poor example because it returned to economic growth not during austerity but after it ended. By 2013, when Blyth’s book was published, the country still wasn’t experiencing growth at the same levels as before the recession, he said. What’s more, sovereign debt levels as a percent of gross domestic product rose in the period.
Blyth pointed to Ireland and Iceland to show what he saw as the bad and good approaches to handling simultaneous economic and banking crises of the Great Recession.
When a housing price bubble popped in Ireland in 2008, three major Irish banks teetered. Over the following months and years the Irish government instituted austerity and spent enormous resources propping up the banking system, Blyth said. Writing in 2013 he said Ireland had, since the recession, remained a bad place to be, with high unemployment, high ratios of debt to GDP, and heavy government spending cuts.
Blyth presented Iceland as a contrast. Prior to the recession many Europeans parked their money in Icelandic banks. The ratio of bank assets to GDP reached more than 11. During the recession international faith in the banks withered, pushing the banks into default.
While Iceland’s government chose to guarantee its residents’ deposits, it didn’t extend the guarantee to foreigners’ deposits.
“Where Ireland followed the mantra of austerity, slashed spending, and bailed its banks, Iceland let its banks go bankrupt, devalued its currency, put up capital controls, and bolstered welfare measures,” Blyth said. Because of this, the Great Recession had a more moderate and short-lived impact on Iceland, he said.
According to Blyth, Iceland shows that a country can let its banks collapse.
However, the situation of Iceland’s banking system was quite different from that of most banking systems as the vast majority of its deposits were made by those outside of the country. The damage that resulted from Iceland’s refusal to backstop foreign deposits almost entirely fell on the economies of other European states.
Further, the reality is that while Iceland’s government let key banks collapse, under International Monetary Fund pressure for a loan in 2010, it voted to pay Britain and the Netherlands up to 6% of Iceland’s GDP from 2017 to 2023 to help cover British and Dutch losses of Iceland bank deposits.
Iceland is also different from many European countries and Puerto Rico in that it had its own currency, the króna, which could devalue on the currency markets. The independent currency was both a positive and a negative to the economy in the Great Recession period and its aftermath.
Since the publication of Blyth's book, the economies of both Ireland and Iceland have done well. Iceland’s inflation-adjusted gross domestic product grew 24.6% to 2018 from 2013, according to the Organization for Economic Cooperation and Development. Its unemployment rate declined to 3.4% in August 2019 from 5.6% in January 2013, according to Eurostat.
Ireland’s inflation-adjusted gross national income grew 18% to 2018 from 2013. Its unemployment rate declined to 5.3% in August from 14.5% in January 2013.
In this past decade’s European economic crises, most of the countries turned to some form of austerity. As mentioned before, Iceland took a different route but was in a unique economic circumstance.
However, Portugal took a somewhat alternative path to dealing with economic contraction, excessive debt, and, for a brief period, inability to borrow more for its deficit spending. Also making it similar to Puerto Rico, Portugal adopted the euro currency from 1999 to 2002.
Portugal had weak economic performance from 2000 to 2014. Indeed, per capita income was lower in 2012 than it was in 2000. Despite repeated government austerity policies, the debt-to-GDP ratio rose from 50% in 2000 to 68% in 2007 and to 126% in 2012.
In 2011 the government could no longer borrow private capital to finance its deficit and it turned to the International Monetary Fund, European Financial Stabilization Mechanism, and European Financial Stability Facility for a 78 billion euros ($86.6 billion) bailout.
After several years of intense austerity from 2011 to 2014, voters in November 2015 brought António Costa to power.
Costa, a leader of Portugal’s Socialist Party, raised the minimum wage, pensions, public sector salaries, and restored the number of vacation days to pre-crisis levels. Creditors like Germany and the International Monetary Fund objected to the policies.
According to the World Bank, Portugal’s inflation-adjusted GDP was slowing its fall from the start of 2012 to mid-2013. By the third quarter of 2013 Portugal’s economy was growing. Thus Portugal’s economy had already been improving for two years when Costa became prime minister. However, it is notable that the economy continued to grow with Costa, lowering the unemployment rate from 12% in late 2015 to 6.2% in August.
Costa has also managed to reduce the government deficit from 4.4% of the GDP when he took office to less than 1% by July 2018. Yet government debt outstanding remains high, according to Moody’s Investors’ Service. It has declined from 130.3% of GDP in 2016 to 123.6% of GDP in 2018 and is expected to continue to shrink in the next few years.
Economic growth alone didn’t achieve this shrinkage. Costa also cut spending on infrastructure and some other areas. So he used at least one classic tool of austerity — cutting government spending — even if he focused on cutting non-traditional areas.
Moody’s rating of Portugal’s debt reached its lowest point since 1986 in Feb. 2012 with a rating of Ba3 with a negative outlook. As of Dec. 18, 2019, Moody’s rated the debt Baa3 with a positive outlook.
Portugal’s economic and fiscal improvement impressed many Europeans. In December 2017 the group of finance ministers whose countries used the euro, the Eurogroup, elected Portugal finance minister Mário Centeno to be its president. Centeno has been the finance minister since Costa became prime minister in late 2015.
Next (on 12/26): Puerto Rico fiscal plan may hurt the most vulnerable